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Can Greece Survive?

Posted on June 25, 2011 | 10 comments

By L. Randall Wray

(Cross-posted with Benzinga.com)

It was obvious to those who understand Modern Money Theory that the set-up of the European Monetary Union was fatally flawed. We knew that the first serious financial and economic crisis would threaten its very existence. In a sense, it was from the beginning much like the US in 1929, on the eve of the Great Depression—with excessive lender fraud, household and business debt, and a boom that had run on too long. Anything could have set off the crisis that followed—just as discovery that Greece had been cooking its books sealed Euroland’s fate. And like the US post-1929, Euroland has struggled to understand and to deal with the crisis. Meanwhile, it is slipping into another great depression.

Many economists and policy-makers—even fairly mainstream ones—have come to recognize that the barrier to resolution is the inability to mount an effective fiscal policy response. And that is because there is no Euro-wide fiscal authority. Hence, the half-measures undertaken by the ECB and other authorities to put band-aids on the debt problem.

To be sure there is a conflict among authorities over the solution—given absence of a fiscal authority. Many want to impose austerity—equivalent to medieval blood-letting. These argue that the real problem is the lack of self-discipline in the periphery countries. Note that this view is shared by the elites in those countries! Many of them would be happy to throw their countries into deep depressions that wipe out all resistance to wage-cutting and slashing of all social programs that benefit working people. That is always the preferred solution of unenlightened elites. Through this method, wage costs in the periphery nations can be cut, making production more competitive.

This of course is also the position of the most powerful member of the EU. Prudent Germany had held wages in check over the past decade while ramping up productivity. As a result, it became the low cost producer in Europe and can even go toe-to-toe and win against Asia. Mind you, not in the production of cheap labor intensive output, but where it really counts in the high value added export sector.

And this view is also common among working classes in the central countries—that share the view of periphery populations as lazy and over-rewarded. While untrue, what is most shocking about this attitude is that if the blood-letting and crushing of wages in the periphery actually does work, the factories will be moved out of Germany seeking lower cost workers. In other words, success in the periphery would shift the burden back to Germany’s workers, who would have to accept lower wages to compete. That will be fueled by job losses if Germany cannot find sales outside the EU that will be lost as the periphery nations fall farther into depression. The result will be a nice little rush to the bottom, benefiting Europe’s elite. How nice.

To be sure, I do not think there is a snowball’s chance in hell that the EU will squeeze sufficient blood out of the Greeks (and Spanish and Italians and Irish and Portuguese) for this to work. What actually makes far more sense is to raise German wages—to achieve competitiveness within the EU by leveling up. But that snowball does not have a chance, either, because Germany is looking far outside the borders of Europe—and mostly in an eastern direction. As a result, it will remain focused on cutting its own labor costs—so the periphery nations will never catch Germany on the way down.

That leaves two alternative approaches. First, continued debt restructuring, ECB purchases through the back door (allowing central banks to buy the debt), guarantees, and lending. The hope is that the financial institutions holding all the periphery government debt can either move it off their balance sheets, or use the American method of “extend and pretend” to avoid recognizing the institutions are insolvent. The problem is that almost all the economic data in recent weeks are bad—almost globally—and that makes it likely there will be some financial hiccup somewhere that will spread as quickly through financial markets as it did in the Global Financial Crisis of 2007.

Many European banks will be recognized to be hopelessly insolvent—with PIIG government debt only adding to the problem. Further, the ECB legitimately worries about the “precedent” and “incentive effects”. This is not really a matter of rules governing what the ECB can do—it has leeway much as the Fed has to intervene in a crisis to essentially buy or lend against virtually any type of asset. It has to do with what the ECB sees to be its independence. Markets would view a US-style bail-out of the European financial system (and by extension, guaranteeing individual government debts) as a loss of its independence. In truth, the ECB already gave that up, but clings to the hope it can somehow get its virginity back.

The third approach is to create the necessary fiscal authority. This would allow the ECB to stick to monetary policy, while giving a European Treasury the purse strings to deal with the crisis. I’ve been arguing since 1996 that is really the only way to make the EU project viable. The economics behind that is simple, adopted in developed countries everywhere. Indeed, the US is effectively an American Monetary Union (AMU) but one properly set up with both a central bank and a treasury. However for political reasons, that ain’t going to happen in the EMU. We are actually further away from that than we were in 1996 because the crisis has increased hostility among the members. No one wants to cede power to the center.

Well, none of those is going to work. What is left? Exiting the union.

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Bill Gross advocates for a Job Guarantee Program

Posted on June 25, 2011 | 3 comments

Bill Gross, co-founder of Pacific Investment Management, recently advocated for an employer of last
resort program:

In the end, I hearken back to revered economist Hyman Minsky – a modern-day economic godfather who predicted the subprime crisis. “Big Government,” he wrote, should become the “employer of last resort” in a crisis, offering a job to anyone who wants one – for health care, street cleaning, or slum renovation. FDR had a program for it – the CCC, Civilian Conservation Corps, and Barack Obama can do the same. Economist David Rosenberg of Gluskin Sheff sums up my feelings rather well. “I’d have a shovel in the hands of the long-term unemployed from 8am to noon, and from 1pm to 5pm I’d have them studying algebra, physics, and geometry.” Deficits are important, but their immediate reduction can wait for a stronger economy and lower unemployment. Jobs are today’s and tomorrow’s immediate problem.

Click here for the full post.

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Whither Greece? Without a national referendum Iceland-style, EU dictates cannot be binding

Posted on June 24, 2011 | 4 comments

By Michael Hudson

The fight for Europe’s future is being waged in Athens and other Greek cities to resist financial demands that are the 21st century’s version of an outright military attack. The threat of bank overlordship is not the kind of economy-killing policy that affords opportunities for heroism in armed battle, to be sure. Destructive financial policies are more like an exercise in the banality of evil – in this case, the pro-creditor assumptions of the European Central Bank (ECB), EU and IMF (egged on by the U.S. Treasury).

As Vladimir Putin pointed out some years ago, the neoliberal reforms put in Boris Yeltsin’s hands by the Harvard Boys in the 1990s caused Russia to suffer lower birth rates, shortening life spans and emigration – the greatest loss in population growth since World War II. Capital flight is another consequence of financial austerity. The ECB’s proposed “solution” to Greece’s debt problem is thus self-defeating. It only buys time for the ECB to take on yet more Greek government debt, leaving all EU taxpayers to get the bill. It is to avoid this shift of bank losses onto taxpayers that Angela Merkel in Germany has insisted that private bondholders must absorb some of the loss resulting from their bad investments.

The bankers are trying to get a windfall by using the debt hammer to achieve what warfare did in times past. They are demanding privatization of public assets (on credit, with tax deductibility for interest so as to leave more cash flow to pay the bankers). This transfer of land, public utilities and interest as financial booty and tribute to creditor economies is what makes financial austerity like war in its effect.

Socrates said that ignorance must be the root of all evil, because no one deliberately sets out to be bad. But the economic “medicine” of driving debtors into poverty and forcing the selloff of their public domain has become socially accepted wisdom taught in today’s business schools. One would think that after fifty years of austerity programs and privatization selloffs to pay bad debts, the world has learned enough about causes and consequences. The banking profession chooses deliberately to be ignorant. “Good accepted practice” is bolstered by Nobel Economics Prizes to provide a cloak of plausible deniability when markets “unexpectedly” are hollowed out and new investment slows as a result of financially bleeding economies, medieval-style while wealth is siphoned up to the top of the economic pyramid.

My friend David Kelley likes to cite Molly Ivins’ quip: “It’s hard to convince people that you are killing them for their own good.” The EU’s attempt to do this didn’t succeed in Iceland. And like the Icelanders, the Greek protesters have had their fill of neoliberal learned ignorance that austerity, unemployment and shrinking markets are the path to prosperity, not deeper poverty. So we must ask what motivates central banks to promote tunnel-visioned managers who follow the orders and logic of a system that imposes needless suffering and waste – all to pursue the banal obsession that banks must not lose money?

One must conclude that the EU’s new central planners (isn’t that what Hayek said was the Road to Serfdom?) are acting as class warriors by demanding that all losses are to be suffered by economies imposing debt deflation and permitting creditors to grab assets – as if this won’t make the problem worse. This ECB hard line is backed by U.S. Treasury Secretary Geithner, evidently so that U.S. institutions not lose their bets on derivative plays they have written up.

This is a repeat of Mr. Geithner’s intervention to prevent Irish debt alleviation. The result is that we enter absurdist territory when the ECB and Treasury insist on “voluntary renegotiation” on the ground that some bank may have taken an AIG-type gamble in offering default insurance or bets that would make it lose so much money that yet another bailout would be necessary. [1] It is as if financial gambling is economically necessary, not part of Las Vegas.

Why should this matter a drachma to the Greeks? It is an intra-European bank regulatory problem. Yet to sidestep it, the ECB is telling Greece to sell off its water and sewer rights, ports, islands and other infrastructure.

This veers on financial theater of the absurd. Of course some special interest always benefits from systemic absurdity, banal as it may be. Financial markets already have priced in the expectation that Greece will default in the end. It is only a question of when. Banks are using the time to take as much as they can and pass the losses onto the ECB, EU and IMF – “public” institutions that have more leverage than private creditors. So bankers become the sponsors of absurdity – and of the junk economics spouted so unthinkingly by the enforcers, cheerleaders for the banality of evil. It doesn’t really matter if their names are Trichet, Geithner or Papandreou. They are just kindred lumps on the vampire squid of creditor claims.

The Greek crowds demonstrating before Parliament in Syntagma Square are providing their counterpart to “Arab spring.” But what really can they do, short of violence – as long as the police and military side with the government that itself is siding with foreign creditors?

The most effective tactic is to demand a national referendum on whether to accept the ECB’s terms for austerity, tax increases, public spending cutbacks and selloffs. This is how Iceland’s President stopped his country’s Social Democratic leadership from committing the economy to ruinous (and legally unnecessary) payments to Gordon Brown’s Labour Party demands and those of the Dutch for the Icesave and even the Kaupthing bailouts.

The only legal basis for demanding payment of the EU’s bailout of French and German banks – and U.S. Treasury Secretary Tim Geithner’s demand that debts be sacrosanct, not the lives of citizens – is public acceptance and acquiescence in such policy. Otherwise the imposition of debt may be treated simply as an act of financial warfare.

National economies have the right to defend themselves against such aggression. The crowd’s leaders can insist that in the absence of a referendum, they intend to elect a political slate committed to outright debt annulment. Across the board, including the Greek banks as well as foreign banks, the IMF and EU central planners. International law prohibits nations from treating their own nationals differently from foreigners, so all debts in specified categories would have to be annulled to create a Clean Slate. (The German Monetary Reform of 1947 imposed by the Allied Powers was the most successful Clean Slate in modern times. Freeing the German economy from debt, it became the basis of that nation’s economic miracle.)

This is not the first such proposal for Greece. Toward the end of the 3rd century BC, Sparta’s kings Agis and Cleomenes urged a debt cancellation, as did Nabis after them. Plutarch tells the story, and also explains the tragic flaw of this policy. Absentee owners who had borrowed to buy real estate backed the debt cancellation, gaining an enormous windfall.

This would be much more the case today than in times past, now that the great bulk of debt is mortgage debt. Imagine what a debt cancellation would do for the Donald Trumps of the economy – having acquired property on credit with minimum equity investment of their own, suddenly owing nothing to the banks! The aim of financial-fiscal reform should be to free the economy from financial overhead that is technologically unnecessary. To avoid giving a free lunch to absentee owners, a debt cancellation would have to go hand in hand with an economic rent tax. The public sector would receive the land’s rental value as its fiscal base.

This happens to have been the basic aim of 19th-century free market economists: tax land and nature – and natural monopolies – rather than taxing labor and capital goods. The aim was to keep for the public what nature and public infrastructure spending create. A century ago it was believed that monopolies such as the privatizers now set their eyes should be operated by the public sector; or, if left in public hands, their prices would be regulated to keep them in line with actual costs of production. Where private owners already have taken possession of land, mines or monopolies, the rental revenue from such ownership privileges would be fully taxed. This would include the financial privilege that banks enjoy in credit creation.

The way to lower costs is to lower “bad” taxes that add to the price of production, headed by taxes on labor and capital, sales taxes and value-added taxes. By contrast, rent taxes collect the economy’s “free lunch,” and thus leave less available to be pledged to banks to capitalize into debt service on higher loans. Shifting the Greek tax burden off labor onto property would reduce the supply price of labor, and also reduce the price of housing that is being bid up by bank credit.

A land tax shift was the primary reform proposal from the 18th and 19th century, from the Physiocrats and Adam Smith down through John Stuart Mill and America’s Progressive Era reformers. The aim was to free markets from the landed aristocracy’s hereditary rents stemming from the medieval Viking conquest. This would free economies from feudalism, bringing prices in line with socially necessary costs of production.

Every government has the right to levy taxes, as long as they do it uniformly to domestic property owners as well as to foreign owners. Short of re-nationalizing the land and infrastructure, fully taxing its economic rent (access payments for sites whose value is created by nature or by public improvements) would take back for the Greek authorities what creditors are trying to grab.

This classical threat of 19th century reformers is the response that the Greeks can make to the European Central Bank. They can remind the rest of the world that it was, after all, the ideal of free markets as expressed from Adam Smith through John Stuart Mill in England, and underlay U.S. public spending, regulatory agencies and tax policy during its period of take-off.

How strange (and sad) that Greece’s own ruling Socialist Party, whose leader heads the Second International, has rejected this centuries-old reform program. It is not Communism. It is not even inherently revolutionary, or at least was not at the time it was formulated. It is socialism of the reformist type that two centuries of classical political economy culminated in.

But it is the kind of free markets against which the ECB is fighting – backed by Treasury Secretary Geithner’s shrill exhortations from the United States. Mr. Obama says nothing leaving it all to Wall Street bureaucrats to set national economic policy. Is this evil? Or is it just passive and indifferent? Does it make much of a difference as far as the end result is concerned?

To sum up, the aims of foreign financial aggression are the same as military conquest: land and the public domain. But nations have the right to tax their rental yield over and above a return to capital investment. Contrary to EU demands for “internal devaluation” (wage cuts) as a means of lowering the price of Greek labor to make it more competitive, reducing living standards is not the way to go. That reduces labor productivity while eroding the internal market, leading to a deteriorating spiral of economic shrinkage.

The need for a popular referendum

Every government has the right and indeed the political obligation to protect its prosperity and livelihood so as to keep its population at home rather than drive them abroad or drive them into a position of financial dependency on rentiers. At the heart of economic democracy is the principle that no sovereign nation is committed to relinquish its public domain or its taxing, and hence its economic prosperity and future livelihood, to foreigners or for that matter to a domestic financial class. This is why Iceland voted “No” in the debt referendum. Its economy is recovering.

Ireland voted “Yes” and now faces a new Great Emigration to rival that which followed the potato famine of the mid-19th century. If Greece does not draw a line here, it will be a victory for financial and fiscal aggression imposing debt peonage.

Finance has become the 21st century’s preferred mode of warfare. It’s aim is to appropriate the land and public infrastructure for its own power elites. Achieving this end financially, by imposing debt peonage on subject populations, avoids the sacrifice of life by the aggressor power – but only as long as subject debtor countries accept their burden voluntarily. If there is no referendum, the national economy cannot be held liable to pay the debts owed even to “senior” creditors: the IMF and ECB. Assets that are privatized at foreign bank insistence can be renationalized. And just as nations under military attack can sue, so Greece can sue for the devastation caused by austerity – the lost employment, lost output, lost population, capital flight.

The Greek economy will not end up with the proceeds of any ECB “bailout.” The banks will get the money. They would like to turn around and lend it out afresh to the buyers of the land, monopolies and other properties that Greece is being told to privatize. The user fees they collect (no doubt raising charges in the process, to cover the interest and pay themselves the usual salary jumps on privatized property) will be paid out as interest. Is this not like military tribute?

Margret Thatcher used to say “There is no alternative” (TINA). But of course there is. Greece can simply opt out of this giveaway of assets and economic privilege to creditors.

What do Mr. Papandreou’s Socialist International colleagues have to say about current events in Greece? I suppose it is clear that the old Socialist International is dead, given the fact that Mr. Papandreou is its head, after all. What passes for socialism today is the diametric opposite of the reforms promoted under its name a century ago, in the era prior to World War I. Europe’s Social Democratic and Labour parties have led the way in privatization, financializing their economies under conditions that have blocked the growth in living standards. The result promises to be an international political realignment.

Economic austerity cannot secure creditor claims in the end

On Thursday afternoon the DJIA, having been down 230 points, leapt up at the close to lose “only” 60 points, on rumors that Greece had agreed to the IMF’s austerity plan. But what is “Greece”? Is it the cabinet alone? Certainly not yet the entire Parliament. Will there be a Parliamentary vote in opposition to the public interest, accepting austerity and privatization?

Only a referendum can commit the Greek government to repay new debts imposed under austerity. Only a referendum can prevent property that is privatized from being re-nationalized. Such a transfer is not legitimate under commonly accepted ideas of political and economic democracy. And in any event, a rent-tax can recapture for the Greek economy what the financial aggressors are trying to seize.

History is rife with instructive examples. Local oligarchies in the region invited Rome to attack Sparta, and it overthrew the kings and their successor Nabis (who may himself have been royal). The sequel is that Rome headed an oligarchic empire, using violence at home to murder democratic reformers such as the Gracchi brothers after 133 BC, plunging the republic into a century of civil war. The creditor interests ended up fully in control, and their own banal self-seeking plunged the Western half of the Roman Empire into an economic and social Dark Age.

Let’s hope the outcome is better this time around. There will indeed be fighting, but more in the financial and fiscal sphere than the overtly military one. The fight ultimately can be won only by understanding the corrosive dynamics of the “magic of compound interest” and the social need to subordinate creditor interests to those of the overall “real” economy. But to achieve this, economic theory itself needs to be brought out of its current post-classical “neoliberal” banality.

[1] Louise Story, “Derivatives Cloud the Possible Fallout From a Greek Default,” The New York Times, June 23, 2011, quotes Christopher Whalen, editor of The Institutional Risk Analyst, as saying: “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”

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MMP BLOG # 3 RESPONSES

Posted on June 23, 2011 | 35 comments

Thank you for comments and questions. Let me divide the responses into several different issues.

1. “Sustainability Conditions” for Government Deficits

I said: “If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Private Balance (+2) + Government Balance (-5) + Foreign Balance (+3) = 0.

And so we are back to the concept of zero!”

Now I want to be clear, I said nothing to imply these particular sectoral balances would continue on through infinity to the sweet hereafter. What I gave was a contingent statement (what the balances would look like AFTER recovery and if we return to LONG-RUN AVERAGES—that is to say, average stances over the past 30 years or so, taking into account trends—essentially just eye-balling the 3 sectors graph provided in the blog). I have made no projection that we actually WILL recover, and it is certainly possible that even after recovery our private sector balance will remain in high surplus. Let us say it remains at 6% (which would be higher than average but consistent with an attempt to delever debt—that is, to keep consumption low in order to pay down debt). In that case, and again assuming the foreign balance remains a positive 3% (that is, our current account deficit is 3%) then the government will remain in deficit of 9% (more or less where it is now). I will not place probabilities on these two outcomes—I think the original statement is more likely—because my main point is simply that taking balances of each of the 3 sectors, the overall balance must be 0.

For those who would like to balance the government budget, the burden is on them to tell me what the implied outcome for the private and foreign sectors will be. If we are not going to return to the disastrous “Goldilocks” outcome with the private sector running deficits, then a huge adjustment will be necessary in the foreign balance in order to have a balanced government budget with a private sector surplus. Virtually none of the deficit hawks consider this. But, again, I would like to hear their explanation for how we will get the current account into surplus.

On to the sustainability conditions. It has become trendy among economist wonks to look at government budget stances to determine whether they could continue forever. Many objections could be raised to such purely mental exercises. An obvious one is that no government has ever lasted forever—and so any such exercise is a waste of time. Ok that one is not something we want to contemplate. Economist Herb Stein quipped that unsustainable processes will not be sustained. Something will change. That gets us somewhat closer to the problem with such approaches. And finally, if we are dealing with sovereign budget deficits we must first understand WHAT is not sustainable, and what is. That requires that we need to do sensible exercises. The one that the deficit hysterians propose is not sensible.

Let us first look at a somewhat simpler unsustainable process. Suppose that some guy—we’ll use the name Ramanan—decides to replicate the “Supersize me” experiment (based on the 2004 documentary by Morgan Spurlock). His caloric intake is 5000 calories a day, and he burns 2000 daily. The excess 3000 calories lets him gain one pound of body weight each day. If he weighed 200 pounds on January 1, by the end of the year he weighs 565 pounds. After 100 years he’s up to 36,700 pounds—a bit on the pudgy side. But we don’t stop there. After 100,000 years he weighs 36,700,000 pounds, and after a few million years, he’s heavy enough to affect the earth’s spin on its axis and its revolutions about the sun. But, according to our policy wonks, that still is not a long enough period—we’ve got to carry this out to infinity, at which point, Ramanan is infinite sized, like the universe, and if he is growing faster than the expansion of the universe, the entire rest of the universe will eventually be infinitesimally smaller than Ramanan. I guess he’s become the black hole of the universe (but I’m no physicist or biologist). So, yes this is unsustainable. Aren’t we all clever?

But would the process actually work that way? Of course not. First, Ramanan is not going to live an infinite number of years; second, he’s either going to blow up (literally) or go on a diet; and third, and most important, his body is going to adjust. As his body mass increases, he will burn more than 2000 calories a day—perhaps he’ll get up to a 5000 calorie a day burn-rate—and his body will use the food in a less efficient manner. So he will stop gaining weight long before he becomes the universe’s black hole. Herb Stein was right.

Our little mental exercise was fundamentally flawed. It assumed a fixed caloric input (flow) and a fixed caloric burn-rate (consumption flow) with the difference between the two accumulating as a stock (weight gain) at a fixed rate (essentially, “savings”). No adjustments to behavior or metabolism are allowed. And then the whole absurd set-up is carried to the ultimate absurdity by the use of infinite horizon projections. Anything carried to a logical absurdity is unsustainable. As you will see, this is the rigged game used by deficit warriors to “prove” the US Federal budget deficit is unsustainable.

The trick used by deficit warriors is similar but with the inputs and outputs reversed. Rather than caloric inputs, we have GDP growth as the input; rather than burning calories, we pay interest; and rather than weight gain as the output we have budget deficits accumulating to government debt outstanding. To rig the little model to ensure it is not sustainable, we have the interest rate higher than the growth rate—just as we had Ramanan’s caloric input at 5000 calories and his burn rate at only 2000—and this will ensure that the debt ratio grows (just as we ensured that Ramanan’s waistline grew without limit). Let us see how this works.

We will start with a simple example similar to the one used in our blog and response last week. Let us have two sectors, government and private. Our government follows the Goldilocks model, spending less than its income (tax revenue); the private sector by identity runs a deficit (spends more than its income). We know this means the private sector is running up debt, held by the government as its asset (surpluses are realized in the form of private sector IOUs). The private sector must service the debt by paying interest; that of course adds to its deficit (interest is additional spending it must make out of its income). In comparison to our Supersizing Ramanan, the sustainability conditions will be determined by the interest rate paid, the growth rate of income (or GDP), and the deficit of the private sector.

Jamie Galbraith laid out the typical model used to evaluate sustainability of deficit spending as follows:

The key formula is:

Δd = –s + d * [(r – g)/(1 + g)]

Here, d is the starting ratio of debt to GDP, s is the “primary surplus” or budget surplus after deducting net interest payments (as shares of GDP), r is the real interest rate, and g is the real rate of GDP growth. (http://www.levyinstitute.org/publications/?docid=1379)

Now, this is wonky but the key idea is that (given a relation between the primary surplus and starting debt–both as ratios to GDP) so long as the interest rate (r) is above the growth rate (g) the debt ratio is going to grow. (Jamie has put these key terms in “real”—that is inflation adjusted—terms but that really does not matter; we can keep it all in nominal terms since “deflation” by the inflation rate merely reduces all terms by the inflation rate). Note that the starting debt ratio (d) as well as the primary surplus (what the private sector’s budget would be if it did not have to pay interest) also play a role. (Galbraith proves that the starting debt ratio does not matter much—just as Ramanan’s initial weight will not matter since in any case he will grow to an infinite size.) But we do not need to get too hung up in math to see that all things equal if the interest rate is above the growth rate, we get a rising debt ratio. If we carry this through eternity, that ratio gets big. Really big. Ok that sounds bad. And it is. Remember, that is a big part of the reason that the GFC hit—overindebted private sector. The GFC is the equivalent to an explosion of Ramanan that would prevent him from growing to an infinite size. (A debt diet would have been far preferable, but Greenspan and Bernanke opposed “interfering” with Wall Street lender fraud.)

Now let us change all this around. Let us say that the government runs a continuous budget deficit while the private sector runs a surplus. We can obtain the same equation. It appears that a continuous government budget deficit implies a continuously rising debt to GDP ratio and surely that is unsustainable. (See the appendix below for more complex math.)

But wait a minute. Is such a mental exercise sensible? We already saw that our supersizing Ramanan is going to adjust: he will diet, explode, increase his metabolism, and reduce the efficiency of his absorption of calories. If he does not explode, he will reach some “equilibrium” in which his intake of calories will equal his burn-rate so that his waistline will stop growing. What about our supersizing government? Here are the possible consequences of a persistent deficit that implies rising interest payments and debt ratios:

  1. Inflation: this tends to increase tax revenues so that they grow faster than government spending, thus lowering deficits. (Many, including Galbraith, would point to the tendency to generate “negative” interest rates.) In other words the growth rate will rise above the interest rate, and reverse the dynamics so that the debt ratio stops growing. (That is equivalent to an increase of Ramanan’s caloric burn rate—so he stops growing.)
  2. Austerity: government can try to adjust its fiscal stance (increasing taxes and reducing spending to lower its defict). Of course, it takes “two to tango”—raising tax rates might not change the government’s balance. It could lower growth rates, and thereby actually increase the rate of growth of the debt ratio.
  3. The private sector will adjust its flows (spending and saving) in response to the government’s stance. If government continually spends more than its income, it will be adding net wealth to the private sector; and its interest payments will add to private sector income. It is not plausible to believe that as the government’s debt ratio goes toward infinity (which means that the private sector’s net wealth ratio goes to infinity) there is no induced spending in the private sector. That is usually called the “wealth effect”. In other words, government debt is private wealth and as private wealth grows without limit this will eventually cause spending to rise relative to private sector income—reducing government deficits. In addition, private sector income includes government interest payments, so rising government interest payments on its debt could induce consumption. When all is said and done, the private sector will not be happy consuming less than its income flow—given its rising wealth—and will adjust its saving behavior. If the private sector tries to reduce its surpluses, this can be done only by reducing the government sector’s deficits. It takes two to tango and the likely result is that tax revenues and consumption will rise, the government’s deficit will fall, and the private sector’s surplus will fall.
  4. Government deficit spending and interest payments could increase the growth rate; it can be pushed above the interest rate. This changes the dynamics and can stop the growth of the debt ratio.
  5. The interest rate is a policy variable (as will be discussed in subsequent weeks). Ignoring all the dynamics discussed in the previous points, to avoid an exploding debt ratio, all the government needs to do is to lower the interest rate below the economic growth rate. End of story, sustainability achieved.

Finally, and this is the most contentious point. Suppose none of the dynamics just discussed come into play, so the government’s debt ratio rises on trend. Will a sovereign government be forced to miss an interest payment—no matter how big that becomes? The answer is a simple “no”. It will take weeks of explication of MMT to explain why. But let us put this in the simple terms that Chairman Bernanke used to explain all the Fed spending to bail-out Wall Street: government spends using keystrokes, or, electronic entries on balance sheets. There is no technical or operational limit to its ability to do that. So long as there are keyboard keys to stroke, government can stroke them to produce interest payments credited to balance sheets.

And that finally gets us to the difference between perpetual private sector deficit spending versus perpetual government sector deficits: the first really is unsustainable while the second is not. Now, I want to be clear. We have argued that persistent government budget deficits that increase government debt ratios and thus private wealth ratios will lead to behavioral changes. They could lead to inflation. They could lead to policy changes. Hence, they are not likely to last “forever”. So when I say they are “sustainable” I merely mean in the sense that sovereign government can continue to make all payments as they come due—including interest payments—no matter how big those payments become. It might choose not to make those payments. And the mere act of making those payments will likely cause changes in growth rates and budget deficits and growth of debt rations.

2. “Sustainability” of Current Account ratios:

In the quote at the top of this response there was also a contingent statement about US current account deficits. To be more clear (and thus to respond to comments), the current account includes the balance of trade (and, more broadly, the balance between exports and imports) plus some other items including “factor payments” (interest and profits paid and received). For the US, we obviously run a trade deficit (and exports are less than imports), but the factor payments are in our favor (we receive more in profits and interest from abroad than we pay to foreign creditors and owners). In any event, our negative current account balance is offset by a positive capital account balance. To put it simply—there is a “flow” of dollars abroad due to the current account deficit that is matched by the “flow” of dollars back to the US due to our capital account surplus. This is often (misleadingly) presented as US “borrowing” of dollars to “pay for” our trade deficit. We could just as well put it this way: the US imports more than it exports because the rest of the world wants to accumulate savings in dollar-denominated assets. I do not want to go into that in detail since it is the subject of later blogs.

But here’s the question. Is a continuous current account deficit possible? A simple answer is yes, so long as “two want to tango”: if the rest of the world wants dollar assets and Americans want rest of world exports (imported to the US), this will continue. But, hold it, say the worriers. As the rest of the world accumulates dollar claims on the US, they also receive interest payments. That is a factor payment that increases our current account deficit. You can see the relation to the point above about government deficits and interest payments. The world will be flooded with dollars twice over: once from our excessive propensity to import and once from our interest payments on debt.

But here is the interesting point: even though the US is the “biggest debtor on earth”, those factor payments flow in our favor. We pay extremely low interest rates and profit rates to foreigners, and earn much higher interest rates and profits on our holdings of foreign investments and debt. Why is that? Because the US is the safest investment on earth. Anytime there is a financial crisis anywhere in the world, where do international investors run? To the US dollar. Ironically, that happens even when the crisis begins in the US! Why? The US has a sovereign government with a sovereign currency. Its interest rate is set by the Fed, which can always set the rate below the US growth rate (and, indeed, as Galbraith points out, the inflation-adjusted interest rate is often below the “real” growth rate). In spite of the deficit hysteria whipped up by hedge fund billionaire Pete Peterson, no investor in her right mind believes there is any default risk on US Treasury debt. So when global fears rise, investors run to the dollar. This could change, but not in your lifetime.

In short, I make no projection about continued US current account deficits but I believe they will continue far longer than anyone imagines. They are sustainable. They will be sustained until the rest of the world decides not to accumulate more dollars and Americans decide they really do not want the cheap junk and environment-destroying oil produced by the rest of the world. When that will happen, I do not know. It is nothing to lose sleep over. Yes we can calculate “sustainability conditions” but it would just be an exercise in mental masturbation. We’ve already done enough of that. I suppose it is titillating but ultimately unsatisfying.

3. Briefly there were several other points raised.

There were some about maldistribution of income as a contributing cause of the private sector deficit. Agreed. There were some questions about stocks and relations to flows. Some of that is treated above but much more will come in the next series of blogs. There were points made about need to regulate Wall Street. Yes! There were questions about QE and the difference between helicopter drops and fiscal policy. Put it this way: Treasury SPENDS money things into existence, the Fed LENDS money things into existence. The first adds income and net wealth, the second only transforms balance sheets. This will be explained in more detail later.

Appendix:

Government debt outstanding (D) follows the following law of motion:

That is, every year, assuming the debt never matures, the outstanding debt increases by the size of the deficit. The deficit is the difference between government spending (G), taxes (T) plus interest payments on outstanding debt (iD)

Let us assume to simplify that G = T so: therefore

The gross domestic product (Y) grows at a rate g and so follows the following law of motion:

Let us find the limit of this ratio:

Following the same logic for Y we get (noting d the debt to gdp ratio)

It is pretty clear that if i > g then the ratio tends toward infinity when n tends toward infinity; and toward zero otherwise. If g = i then dt = d0 for all t.

The complication of the deficit to GDP ratio at 5% would mean:

Without going too far into the implications we have:

Therefore by doing a recursive calculation we get:

As n tends toward infinity dt also does. Note that a given deficit to gdp ratio means that deficit has to explode as gdp increases.

Thanks: to James Galbraith and Eric Tymoigne.

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Dawn of the Gargoyles: Romney Proves He’s Learned Nothing from the Crisis

Posted on June 22, 2011 | 2 comments

By William K. Black

Mitt Romney chose to unveil the economic plank of his campaign for the Republican nomination with a speech in Aurora, Colorado decrying banking regulation.  He could not have picked a more symbolic location to make this argument, for Aurora is the home and name of one of the massive financial frauds that caused the Great Recession.  Lehman Brothers’ collapse made the crisis acute and Lehman’s subsidiary, Aurora, doomed Lehman Brothers.  Lehman acquired Aurora to be its liar’s loan specialist.  The senior officers that Lehman put in charge of Aurora, which was inherently in the business of buying and selling fraudulent loans, set its ethical plane at subterranean levels.


Aurora sealed Lehman’s fate by serving as a “vector” that spread an epidemic of mortgage fraud throughout the financial system and caused catastrophic losses far greater than Lehman’s entire purported capital.  Aurora epitomizes what happens when we demonize the regulators and create regulatory “black holes.”  Romney literally demonized banking regulators as “gargoyles” and claimed that banking regulations and regulators were the cause of the economy’s weak recovery.

On April 20, 2010, I testified before the Committee on Financial Services of the United States House of Representatives regarding Lehman’s failure.  I was the witness chosen by the (then) Republican minority because they wished to have testimony from an experienced and successful financial regulator who would pull no punches in critiquing the failures of the Federal Reserve Bank of New York (FRBNY), the Board of Governors of the Federal Reserve (the Fed), and the Securities and Exchange Commission (SEC) with regard to Lehman.  The Republicans’ target was the former President of the FRBNY, Timothy Geithner. 
My House testimony explained why Aurora was the key to understanding Lehman’s failure and the causes of the financial crisis. 
Lehman was a “control fraud.”  That is a criminology term that refers to situation in which the persons controlling a seemingly legitimate entity use it as a “weapon” (Wheeler & Rothman 1982) of fraud (Black 2005).   Financial control frauds’ “weapon of choice” for looting is accounting.
Lehman’s nominal corporate governance structure was a sham.  Lehman was deliberately out of control with regard to “risk” in its dominant operation – making “liar’s loans.”  Lehman did not “manage” the risk of making liar’s loans.  It engaged in massive, fraudulent transactions that were “sure things” (Akerlof & Romer 1993).  The Valukas Report … provides further evidence of the accuracy of George Akerlof and Paul Romer’s famous article – “Looting: Bankruptcy for Profit.”  The “looting” that Akerlof & Romer identified is a “sure thing” in both directions – firms that loot through accounting scams will report superb (fictional) income in the short-term and catastrophic losses in the long-term. 

The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.[1]
     
This roughly $9 billion loss, in 2008, was an important factor in destroying Lehman, but it represents only losses on liar’s loans still held in portfolio.  Aurora specialized in making liar’s loans and Aurora’s loans caused massive losses because they were pervasively fraudulent.    Lehman sold tens of billions of dollars of liar’s loans through Aurora and a subsidiary (BNC Mortgage) that specialized in making subprime loans – roughly half of which were liar’s loans by 2006.  The purchasers of these fraudulent loans had the legal right and economic incentive to require Lehman to repurchase the loans, which would have far exceeded Lehman’s reported capital.  Making and selling fraudulent liar’s loans doomed Lehman.  Lehman was one of the largest vectors that spread fraudulent mortgage paper throughout much of Europe and the United States.
Lehman had become the only vertically integrated player in the industry, doing everything from making loans to securitizing them for sale to investors.

***

Lehman was a dominant player on all sides of the business. Through its subsidiaries – Aurora, BNC Mortgage LLC and Finance America – it was one of the 10 largest mortgage lenders in the U.S. The subsidiaries fed nearly all their loans to Lehman, making it one of the largest issuers of mortgage-backed securities. In 2007, Lehman securitized more than $100-billion worth of residential mortgages.

These demands posed a much larger problem: contagion. Because these CDOs were thinly traded, many of them did not yet reflect the loss in value implied by their crumbling mortgage holdings. If Bear Stearns or its lenders began auctioning these CDOs off, and nobody wanted to buy them, prices would plummet, requiring all banks with mortgage exposure to begin adjusting their books with massive writedowns.

Lehman, despite its huge mortgage exposure, appeared less scathed than some. Mr. Fuld was awarded $35-million in total compensation at the end of the year.

The volume of liar’s loans and subprime loans was everything – as long as Lehman could sell the liar’s loans to other parties.  Volume created immense real losses, but it also maximized Dick Fuld’s compensation.  Nonprime loans drove Lehman’s (fictional) gains in income and capital under Fuld.

Lehman’s real estate businesses helped sales in the capital markets unit jump 56 percent from 2004 to 2006, faster than from investment banking or asset management, the company said in a filing. Lehman reported record earnings in 2005, 2006 and 2007.

As MARI, the mortgage lending industry’s own anti-fraud experts, warned the industry in 2006, making liar’s loans is an “open invitation to fraudsters.”  Even Lehman’s internal studies found, by reviewing only the loan files, exceptional levels of fraud.

Mark Golan was getting frustrated as he met with a group of auditors from Lehman Brothers.
It was spring, 2006, and Mr. Golan was a manager at Colorado-based Aurora Loan Service LLC, which specialized in “Alt A” loans, considered a step above subprime lending. Aurora had become one of the largest players in that market, originating $25-billion worth of loans in 2006. It was also the biggest supplier of loans to Lehman for securitization.
Lehman had acquired a stake in Aurora in 1998 and had taken control in 2003. By May, 2006, some people inside Lehman were becoming worried about Aurora’s lending practices. The mortgage industry was facing scrutiny about billions of dollars worth of Alt-A mortgages, also known as “liar loans”– because they were given to people with little or no documentation. In some cases, borrowers demonstrated nothing more than “pride of ownership” to get a mortgage.
That spring, according to court filings, a group of internal Lehman auditors analyzed some Aurora loans and discovered that up to half contained material misrepresentations. But the mortgage market was growing too fast and Lehman’s appetite for loans was insatiable. Mr. Golan stormed out of the meeting, allegedly yelling at the lead auditor: “Your people find too much fraud.”


After the FBI warned in September 2004, that there was an “epidemic” of mortgage fraud, after Lehman’s internal auditors found endemic fraud in their liar’s loans, after MARI warned the industry in 2006 that studies of liar’s loans found a fraud incidence of 90%, after the bubble had stalled in 2006, and after scores of mortgage banks that specialized in making nonprime loans failed – Lehman significantly increased the rate at which Aurora made liar’s loans.  In 2006, Aurora originated roughly $2 billion a month.

BNC was Lehman’s subsidiary that specialized in subprime loans.  By 2006, roughly half of its loans were liar’s loans to borrowers with poor credit records.
 
Lehman’s pattern of conduct seems bizarre because no honest firm would make liar’s loans.  The pattern, however, is optimal for an accounting control fraud.  The people who control fraudulent lenders optimize their compensation by maximizing the bank’s short-term reported income.  The “recipe” for maximizing fictional income (and real losses) has four ingredients:
  1. Extremely rapid growth by
  2. Making poor quality loans at a premium yield while employing
  3. High leverage and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)
The officers controlling a fraudulent lender find it necessary to eviscerate the bank’s underwriting in order to be able to make large amounts of bad loans.  The managers deliberately create a fraud-friendly culture, and Aurora demonstrated how extreme the embrace of fraud could become.   
The HR lady pulled Michael Walker into a room and told him he was fired.
The reason: Talking to the FBI. It was a violation of the company’s privacy policy.
“I was stunned,” Walker told me. “I couldn’t believe it. But that’s what she said.”
Walker, a “high-risk specialist,” was then walked out of the building as if he were the risk. His job at Aurora Loan Services LLC, Littleton, Colo., ended on Sept. 4, 2008.
His job was to uncover mortgage fraud. But he claims he was fired for doing it. In a lawsuit recently filed in Denver District Court, he claims Lehman’s mortgage subsidiary wanted to remain profitably unaware of fraud. 

Aurora [personnel] got paid by loan volume, not by loan quality.
Consequently, Walker and his fraud-seeking colleagues were always busy.
“They just absolutely flooded us with work,” he said. “There was no way we could possibly keep up with it. And that’s what they wanted.
“They were putting the loans into an investment trust,” he explained.  “When they became aware of fraud, they had to buy those loans back out of the trust. So it ended up costing them money.”
But Walker couldn’t play this game.  A “Suspicious Activity Report” that he filed in 2006 led to interviews with the FBI and the IRS in 2008, and then ultimately to his bizarre dismissal.[2]
Lehman’s senior managers consciously chose to take the unethical path because they knew it generate extraordinary reported income in the short-term, which would maximize their compensation.  Prior to becoming one of the world’s largest purchasers and sellers of nonprime loans through Aurora and BNC, Lehman had eagerly embraced fraudulent and predatory lending.  The officers who controlled Lehman also showed in this earlier episode that they would choose that short-term reported income that maximized their compensation even when they were warned that it was produced by fraud and abuse of the customers and knew that the loans would produce large losses,
Mr. Hibbert was a vice-president at Lehman Brothers and he’d been sent to meet First Alliance founder Brian Chisick to see if Lehman could form some kind of relationship with the mortgage lender.

[Hibbert] pointed out that “there is something really unethical about the type of business in which [First Alliance] is engaged.”

Mr. Chisick had become one of the biggest players in subprime loans. First Alliance’s annual revenue had doubled in four years to nearly $60-million (U.S.) and its profit had increased threefold to $30-million.

“It is a sweat shop,” [Hibbert] wrote. “High pressure sales for people who are in a weak state.” First Alliance is “the used car salesperson of [subprime] lending. It is a requirement to leave your ethics at the door. … So far there has been little official intervention into this market sector, but if one firm was to be singled out for governmental action, this may be it.”

Despite the warning, Lehman officials recommended a $100-million loan facility for First Alliance. Mr. Chisick turned it down, but he agreed to take a $25-million line of credit and hire Lehman to work with Prudential on several securitizations.

At this juncture, Hibbert’s warnings of a governmental response proved accurate.  Various state Attorneys General began to sue First Alliance for consumer fraud.  Prudential terminated its ties with the lender.

But Lehman jumped at the opportunity to move in. Senior vice-president Frank Gihool asked Mr. Hibbert to pull together a review of First Alliance for Lehman’s credit risk management team. Mr. Hibbert once again marvelled at the company’s operations and financial outlook. But he also said the lawsuits posed a serious problem. The allegation about deceptive practices “is now more than a legal one, it has become political, with public relations headaches to come,” he wrote.

Nonetheless, on Feb. 11, 1999, Lehman approved a $150-million line of credit, and became the company’s sole manager of asset-backed securities offerings. The bottom line for Lehman was made clear in another internal report: The firm expected to earn at least $4.5-million in fees.
But within a year, the weight of the lawsuits crippled First Alliance. On March 23, 2000, the company filed for bankruptcy protection. Mr. Chisick managed to walk away with more than $100-million in total compensation and stock sales over four years. Lehman, owed $77-million, collected the full amount, plus interest.

First Alliance eventually settled the lawsuits filed by the state attorneys, agreeing to pay $60-million. In the California class-action case, a jury found Lehman partially responsible for First Alliance’s conduct and ordered the firm to pay roughly $5-million.

Romney is Echoing the Anti-regulatory Dogma that Caused the Crisis

Aurora and BNC Mortgage were regulatory “black holes.”  The Fed had unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to regulate all mortgage lenders and had unprecedented practical leverage during the crisis because of its ability to lend to investment banks and convert them to commercial bank holding companies.  Fed Chairmen Greenspan and Bernanke, despite pleas from Dr. Gramlich, refused to use this authority to close the regulatory black hole.  Bernanke finally, under repeated pressure from Congressional Democrats, used the Fed’s HOEPA authority in August 2008 – over a year too late to even minimize losses.  Greenspan and Bernanke were chosen to lead the Fed because of their intense, anti-regulatory dogma.  Greenspan was notorious for his assertion that fraud provided no basis for regulation.  He believed that financial markets automatically excluded fraud.   
The SEC was equally notorious for its anti-regulatory policies.  It created the disgraceful non-regulation regulation of Lehman and its four sister investment banks.  The Consolidated Supervised Entities (CSE) program never made the SEC a real “primary regulator.”  The SEC is incapable, as constituted, staffed, and led to be a primary regulator of anything – and that includes the rating agencies.  “Safety and soundness” regulation is a completely different concept than a “disclosure” regime.  The SEC’s expertise, which it has allowed to rust away for a decade, is in enforcing disclosure requirements.  The SEC did not have the mindset, rules, or appropriate personnel to make the CSE program a success even if the agency had been a “junk yard dog.”  Given the fact that the SEC was self-neutered by its leadership during the period Lehman was in crisis in 2001-2008, there was no chance that it would succeed even if the CSE been a real program.
The reality is that the CSE was a sham.  The EU announced that it would begin regulating foreign investment banks doing business in the EU unless they were subject to consolidated supervision by their domestic regulator.  The U.S., however, had no consolidated supervision of investment banks.  The five largest U.S. investment banks were scared of the prospect of EU regulation.  Their solution was for the SEC to create a faux regulatory system.  The SEC assigned three staffers to be primarily responsible for each of the five, massive investment banks. In order to examine and supervise an entity of their size and complexity, a realistic staff level would begin at 150 regulators per investment bank.       
 
The SEC’s only hope with respect to Lehman was to form an effective partnership with the Fed.  An SEC/Fed partnership would at least have some chance.  The Valukas report reveals that the FRBNY staff at Lehman recognized that the SEC’s staff at Lehman’s offices was not capable of understanding its financial condition.
Why we suffered the Great Recession and such a slow recovery
The primary cause of severe bank failures has long been senior insider fraud (James Pierce, The Future of Banking (2001).  We know the characteristics that cause the criminogenic environments that produce the epidemics of accounting control fraud that cause our recurrent, intensifying crises.  Two of the most important factors are the “three de’s” – deregulation, desupervision, and de facto decriminalization – and perverse executive, professional, and employee compensation.  These two factors were principally responsible for creating the epidemic of mortgage fraud that drove our crisis.  Financial regulation was effectively destroyed in the U.S. 
The primary function of financial regulators is to serve as the “regulatory cops on the beat.”  “Private market discipline” was an oxymoron – financial firms are supposed to provide the discipline by denying credit to poorly managed and overly risky firms.  They are supposed to be impervious to fraud.  The reality is that they fund the frauds’ rapid growth.  Fraud begets fraud.  George Akerlof warned of this perverse “Gresham’s” dynamic in his famous 1970 article about “lemon’s” markets.  When fraud provides a competitive advantage market forces become perverse and drive ethical firms from the marketplace.  Effective, vigorous financial regulation is essential to break this Gresham’s dynamic.  The regulatory cops on the beat must take the profit out of fraud.
There are several reasons why the economic recovery is weak and there is a great danger of recurrent recessions.  My colleagues on this blog have explained the macroeconomic reasons so I will concentrate on the regulatory barriers to recovery.  Suffice it to say that my colleagues have shown that the recovery is not weak primarily due to credit restraints by banks on lending to corporations.  The regulatory barriers to recovery are the opposite of what Romney asserts.  Financial regulation in the U.S. remains extraordinarily weak.  President Obama has largely kept in power and even promoted Bush’s financial wrecking crew.  Larry Summers and Timothy Geithner are fierce anti-regulators.  The Republicans have blocked vital appointments to the Fed – under the claim that a Nobel Prize winner in economics lacks sufficient expertise to serve on the Fed.  The Republicans, while claiming that Fannie and Freddie pose a critical risk to the nation; have blocked the appointment of a superbly qualified head of the agency that is supposed to regulate Fannie and Freddie.  The Republicans have blocked the appointment of Elizabeth Warren to head the Consumer Finance Protection Bureau.  Warren (a) warned of the coming nonprime disaster, (b) is superbly qualified to lead the bureau, and (c) is a remarkably pleasant and unassuming Midwesterner.  The head of the SEC was named based on her experience as a failed leader of self-regulation.  Bernanke named as the Fed’s top supervisor an anti-regulatory economist with no experience in examination or supervision.  Bernanke then, absurdly, claimed that his appointment made the agency more inter-disciplinary.  The reality is that it simply made theoclassical economists dominant in the one senior professional post that previously provided the Fed with an alternative policy perspective and real expertise.  Attorney General Holder has largely continued the Bush administration’s policy of allowing the elite bank frauds to proceed with impunity. 
The Republicans are trying to force severe cuts in the already inadequate budgets of the financial regulatory agencies.  The flash clash revealed that the SEC does not have the internal capacity to monitor or even study retrospectively hyper-trading, which has become increasingly dominate.  The SEC will not be provided with sufficient budget to even develop a system to monitor and study hyper-trading.  The commodity markets are being subjected to exceptional manipulation.  The Commodities Futures Trading Commission (CFTC) has announced that it cannot afford to develop the systems essential to detect and track commodity speculation.  Instead of demanding that the CFTC develop such an essential system the Republicans are seeking to slash the CFTC’s already grossly inadequate budget. 
      
Romney’s claim that this group of understaffed and funded regulators led by senior anti-regulators constitutes “gargoyles” that have terrified the systemically dangerous institutions (SDIs) that dominate our finance system is ludicrous.  There isn’t an SDI in the U.S. that fears its regulators.  The regulators are like gargoyles – they may scare children but one soon learns that they are immobile stones that do not see, bite, or even growl.  They are perches and canvasses for pigeons and their droppings.
Epidemics of accounting control fraud cause severe economic crises and harm recoveries in myriad ways.  First, fraud causes far more severe losses.  Second, fraud erodes trust because the essence of fraud is the creation and betrayal of trust.  Trust can take many years to recover.  The number of middle class Americans willing to invest in the stock market has still not recovered from the Enron era frauds.  Third, as Akerlof & Romer (1993) warned, accounting control fraud epidemics can cause bubbles to hyper-inflate.  Severe bubbles make markets grossly inefficient.  Japan demonstrates that it can take over a decade for the prices to fall to levels where the markets will “clear.”  The catastrophic nature of the losses and their concentration in financial institutions leads to the temptation to change the accounting rules to cover up the banks’ losses.  We refused to do so during the S&L debacle and the result was a prompt recovery.  We, like Japan, gave in to the banks’ demands during this crisis and the result is an impaired recovery.  Fourth, the endemic mortgage fraud by lenders led to endemic foreclosure fraud because fraudulent lenders (a) keep extremely poor records and (b) a number of the largest servicers are staffed with personnel from the firms that made the fraudulent loans.  The foreclosure fraud is harmful both because it defrauds the innocent and because it shields the most abusive borrowers from prompt foreclosures.  Fifth, the fraud and the hyper-inflated bubble lead to a severe drop in private wealth and demand and household pessimism.  The household sector has not been able to provide the demand to produce a strong recovery.  Sixth, because we pretend that insolvent banks are healthy and keep them under the leadership of the inept and even fraudulent managers who caused them to become insolvent we end up with Japanese-style crippled banks that prefer to clip coupons rather than make commercial loans.         
Romney is replaying the absurd and harmful propaganda of 1986-1987.  S&L regulation was critically weak, which is what made the S&L industry so criminogenic.  The industry trade association, however, claimed that regulation was oppressive.  We, the S&L Federal Home Loan Bank Board Chairman Edwin Gray with any funds and any additional regulatory powers to counter the accounting control frauds that were running wild.  Instead, in the Competitive Equality in Banking Act of 1987 (CEBA), Congress mandated “forbearance” designed to gut our power to close the frauds.  This was not Congress’ intent – they did not consciously seek to aid the frauds.  The worst S&L frauds, however, formed what a prominent CEO called a “Faustian bargain” with the S&L trade association to counter our proposed legislation.  The result of that Faustian bargain was that language was inserted in our proposed bill that was framed by the frauds’ lobbyists for the express purpose of making it far more difficult for us to close the frauds.  Until we took on their political patrons and spent months explaining to members of Congress, their staffs, and the media how the proposed amendments would damage our ability to act effectively against the frauds these claims that the regulators were ogres were taken as true by most politicians.  All their political contributors said it was true.  The reality was, of course, the opposite as virtually everyone now agrees.  S&L regulation had been nearly non-existent.  With the aid of Representatives Gonzalez, Leach, Carper, and Roemer and Senator Gramm (yes, that Senator Gramm!) we were able to make subtle changes in the CEBA bill that undid the worst of the frauds’ amendments. 
Will the Obama administration be willing to fight like we did to save the effort to put the fraudulent S&Ls in receivership, remove the scam accounting rules, toughen regulation, and prosecute the fraudulent senior officers?  Or will it give in to Romney’s propaganda and its desire to raise vast sums in political contributions from finance executives by weakening the already criminally weak Dodd-Frank Act?  The administration’s most recent action has been to delay adoption of the rules implementing the Act.  It wants banks to be able to continue the disastrous practices that made the crisis worse and that the Dodd-Frank Act sought to prohibit. 
Here are the key passage and question arising from Romney’s speech: 
“Almost everything the president did had the opposite effect of what was intended,” Romney said. “He said, okay, we’re not going to re-regulate the banking sector. Well, what he caused was the banking sector to pull back, and that’s the very sector that’s got to step forward to help get the economy on its feet again.”

The question to President Obama is:  “Was Mr. Romney correct when he said that you decided not to ‘re-regulate the banking sector’?”  And the follow-up question, if your answer is “yes” is:  “If the Great Recession and the epidemic of bank fraud is not sufficient for you to reregulate the banking sector – what will it take?”  Secretary Geithner and Chairman Bernanke state that the unregulated banking sector caused catastrophic losses and, but for extraordinary government intervention, would have caused the Second Great Depression.  Effective banking regulation is essential to protect the public and honest banks.  Both parties’ economic policies, however, are dominated by theoclassical economic dogma.  Breaking the death grip of this criminogenic dogma on theory and policy is the economic profession’s most pressing need.  Economists, and the politicians who find parroting their anti-regulatory policies so useful in raising campaign contributions, are the greatest threat to the economy.

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Marshall Auerback Interviewed on Squeeze Play

Posted on June 21, 2011 | 2 comments

NEP Blogger Marshall Auerback was interviewed yesterday on Greece and the Eurozone on BNN’s Squeeze Play.  Click here to watch.

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Can Sesame Street Help Europe’s Finance Ministers Understand the Debt Crisis? (Members of Congress Take Note)

Posted on June 20, 2011 | 12 comments

By Stephanie Kelton

You might expect the head of the group of countries that use the euro to understand the common currency better than anyone. You would be wrong.

Jean-Claude Juncker, head of the Eurozone’s group of finance ministers, can’t figure out why financial markets are so anxious about Europe’s ability to service its debt and so unconcerned about debt levels in other parts of the world. He’s convinced that Europe’s fundamentals are better than ours, so he can’t figure out why investors are gobbling up Treasuries despite the “disastrous” debt level here in this United States. To him, financial markets appear to be getting it badly wrong. He said:

“The real problem is that no one can explain well why the euro zone is in the epicenter of a global financial challenge at a moment, at which the fundamental indicators of the euro zone are substantially better than those of the U.S. or Japanese economy.”

Well, Mr. Junker, not only have we – the scholars of MMT – explained why the debt crisis hit members of the Eurozone, we also predicted that the design of the euro system would lead, precisely, to this outcome. Even before the launching of the euro, people like Charles Goodhart, Wynne Godley, Jan Kregel and Warren Mosler were sounding the alarms, warning that the Maastricht Treaty contained a dangerous design flaw that would strip member nations of their power to safely expand their deficits in times of economic crises. And so while mainstream economists like Willem Buiter were busy arguing over the appropriateness of the 3% deficit-to-GDP and 60% debt-to-GDP limits established under the Stability and Growth Pact (SGP), those of us working in the MMT tradition were busy pointing out that bond markets, not the SGP, would impose the relevant constraint under the new monetary system. I wrote in 2003:

“[B]y forsaking their monetary independence and agreeing to the terms set out in Article 104 of the Maastricht Treaty …. obligations issued by EUR-11 governments begin to resemble those issued by state and local governments in the United States ….. Since markets will perceive some members of the EUR-11 as more creditworthy than others, financial markets will not view bonds issued by different nations as perfect substitutes. Therefore, high-debt countries may be unable to secure funding on the same terms as their low-debt competitors. ….. if interest payments are becoming a significant portion of a member state’s total outlays, it may be difficult to convince financial markets to accept new issues in order to service the growing debt.”

As a group, we warned that without a fiscal analogue to the ECB, the euro was essentially an accident waiting to happen – a sort of ticking bomb, ready to ignite the periphery at the slightest strain on public budgets. We wrote pamphlets, articles, chapters and books, travelled the Eurozone, met with elected officials, appeared on television, radio, and in print media.

We explained that the issuer of a non-convertible fiat currency never faces an external funding constraint. The United States, Japan, the United Kingdom, Australia and Canada can always pay their debts on time and in full. They cannot “go broke” or be forced to default on their obligations.

In contrast, we explained that Greece, Portugal, Ireland and the rest of the Eurozone nations have become users of their currency. They cannot create the euro. They can become insolvent, and they can be forced into default. And yet Mr. Junker claims that no one has been able to explain why the Eurozone remains in the epicenter of a global financial crisis.

Today, we continue to write about what went wrong and what the ECB could do to restore prosperity. William Black, Randy Wray, Marshall Auerback, William Mitchell, Warren Mosler, and I have worked tirelessly to explain that countries that are USERS of their currency just aren’t like the U.S. and Japan.

Perhaps we have been too opaque. Let’s try something simpler. Carefully study the images below.

Now watch this:

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It Became Necessary to Destroy the Periphery in Order to Save the Core’s Banks

Posted on June 20, 2011 | 4 comments

By William K. Black

* Cross-posted with Benziga

Gary O’Callaghan, a former IMF economist has written about his distress over what he views as the European Central Bank’s (ECB’s) destructive policies toward the periphery. 

The ECB, EU, and the IMF are the troika that contributed to the periphery’s crises and have responded in such a destructive manner to the crises.  O’Callaghan’s column urges the European finance ministers to focus on “three simple questions about the [troika’s] Irish, Greek and Portuguese” loan programs.  My column focuses on the reasoning underlying his third question.

“Third, how important is it that the programs succeed?  Obviously it is crucial.  The success of the programs is key to the survival of the euro and should, therefore, take precedence over any other European agenda.” 

O’Callaghan, unintentionally, has disclosed the core irrationality that underlies the euro.  It is not “obvious” that “the survival of the euro” is critical, much less a goal of such transcendent importance that it should “take precedence over any other European agenda.”  The euro is simply instrumental to some substantive purpose such as economic security, employment, or at least increased efficiency.  The economic welfare of the people of the EU should be the EU’s transcendent economic goal.    

O’Callaghan conflated “the survival of the euro” with the transcendent “European agenda” and the success of the EU loan programs to Ireland, Greece and Portugal with “the survival of the euro?”  The EU existed for decades without the euro.  A number of EU nations have chosen not to be members of the euro.  The euro is not essential to an effective EU unless the EU wishes to become a true United States of Europe.  That new sovereign nation would want a sovereign currency.  The crisis had revealed that most French, Germans, and Finns do not view the Irish, Greeks, and Portuguese as fellow citizens of a United Europe.  O’Callaghan calls on the EU to the discard the concept of European solidarity as “distracting rhetoric,” but he does not see that the euro has become one of the greatest threats to any “European agenda.” 

Why is O’Callaghan so disturbed about the EU and ECB’s lending program for Ireland?  He is part of the IMF’s vast alumni corps and he’s horrified that the EU and the ECB are making the rookie mistakes common to novice loan sharks.  The IMF knows how to bleed a nation – and it knows why the IMF bleeds nations.  The IMF does not bail out poor nations.  It bails out banks in rich nations that have made imprudent loans to poor nations.  The IMF realizes that it is essential not to impose so much austerity that you kill rather than cripple the victim’s economy and harm the core’s banks.  The ECB is dominated by theoclassical economists who have not yet learned this lesson.  Their economic dogma is a variant on the old joke:  the daily floggings will continue until morale improves around here.  Bleeding is virtuous.  If the victims aren’t screaming the ECB is not trying hard enough.

O’Callaghan writes primarily to convince the EU and the ECB to dial back the bleeding to the point where it is just sustainable.  He urges them to “eliminate [] immediately” “punitive interest rates that  undermine the chances of success.”  O’Callaghan describes the ECB’s current loan terms as so bad that they are “preposterous.”  “The rating agencies, the markets and most leading economists do not believe the plan is working.” 

Sentient economists do not believe that imposing austerity during a severe recession is sensible.  The CIA world book describes Ireland’s austerity program – prior to ECB demands for ever greater austerity – as “draconian” (and the CIA has special expertise with regard to the concept of “draconian”).


O’Callaghan key admission – the bailouts are essential to bail out the core’s banks

Why does O’Callaghan argue that it is essential that the ECB plan for the periphery succeed? 

Because, it they are not implemented, the non-payment of debt – including bank debt – by the nations on the periphery would lead to severe banking crises and a return to recession in the core of eurozone.

That concession is refreshingly candid.  The EU is not lending money to Ireland, Greece, and Portugal to help those nations’ citizens.  The EU is lending those nations money because if they don’t those nations and their citizens and corporations will be unable to repay their debts to banks in the core.  That will make public the fact that the core banks are actually insolvent.  When the Germans and French realize that their banks are insolvent the result will be “severe banking crises and a return to recession in the core of the eurozone.”  The core, not simply the periphery, will be in crisis. The ECB and the EU’s leadership would be happy to throw the periphery under the bus, but the EU core’s largest banks are chained to the periphery by their imprudent loans.             

Destructive EU feedback loops: bad economics breed bad politics and worse economics

The leaders of the troika understand, but detest, the need to bail out the core’s insolvent banks by bailing out the periphery.  They understand how much the EU public detests the bailouts and the resultant political cost in the core of supporting the bailouts.  Their efforts to minimize that political cost lead them to demonize the periphery and support the ECB’s imposition of ever more draconian and self-defeating austerity programs on the periphery.  The austerity programs are deepening the recessions in the periphery and creating far worse unemployment.  The perverse economic policies create ever greater political instability in the periphery, massive resistance to austerity, and contempt for the core nation’s pretenses about European solidarity.  As the perverse austerity programs cause the periphery’s recessions to deepen the likelihood that the likelihood of default increases, which further outrages the core’s population and threatens to unseat the core’s political leaders.  Austerity locks the core and the periphery in a totentanz – a dance of death.  The desire to save the euro and the core’s insolvent banks has become the greatest threat to the EU project.

Creating a sounder euro system

Even if the EU did need the euro, it does not need every EU member to be in the euro.  If Ireland, Greece, and Portugal were to leave the euro and reintroduce sovereign currencies the number of EU nations using the euro would be greater than during the period the euro was introduced.  The remaining members would have more uniform economies that would be closer to the economic concept we call an “optimum currency area” – making the new euro far less dangerous.  That would make the euro and the EU’s member states stronger – both the core and the periphery.   

The euro is ulcerous.  The EU and ECB leadership do not understand this point.  They see the obvious; the euro is “strong” relative to the other major currencies.  Look underneath and the ulcers are weeping.  The euro is so strong because the U.S., Japan, and China are deliberately and generally successfully weakening their currencies in order to increase exports.  They all have sovereign currencies.  They borrow at exceptionally low interest rates with U.S. and Japanese debt levels roughly equivalent to or in excess of Ireland, Greece, and Portugal.  

The euro has become the tail that wags the EU dog, and it is wagging so destructively that it is throwing the periphery into the ditch.  The EU response is to make the periphery dig itself ever deeper into that ditch and while showering the periphery with abuse.  O’Callaghan’s assertion that it was “obvious” that the survival of the euro, not the well being of EU citizens, was the EU’s transcendent goal demonstrates the point.  The euro is the problem – not the solution – for the periphery and the core.    

It is essential that the nations of the EU periphery reclaim their sovereignty.  Sovereign nations have a range of policy options to recover from recessions.  They can lower interest rates, devalue their currencies, and increase public spending to offset lost demand in the private sector.  Recessions cause real, severe economic and social losses.  Unemployment is a pure deadweight loss.  In a serious recession in a nation such as the U.S., the losses are measured in the trillions of dollars.  Speeding the recovery from recession, ending unemployment, and avoiding hyper-inflation should be a sovereign nation’s transcendent economic goals at this time. 

Because they lack sovereign currencies Ireland, Greece, and Portugal cannot effectively use any of these three means of fulfilling a sovereign nation’s economic functions.  They cannot devalue.  They cannot set monetary policy – they can’t even influence it.  They can run small deficits.  Small deficits do not come close to replacing the severe loss of private sector demand that occurs in serious recessions, so the EU “Growth and Stability Pact” is a double oxymoron.  It limits growth, causes economic instability by leading to widespread unemployment, and causes political instability.  It hamstrings the one thing we know reliably works to limit recessions – automatic stabilizers – by allowing them to only partially stabilize.  The EU, as a matter of policy, provides far less effective automatic stabilizers than does the U.S. – in the name of producing “stability.”  Neoclassical ECB economists, the designers and implementers of the euro and ECB, studiously ignore the significant insanity of this policy.

A functional sovereign nation addresses its home grown problems rather than ignoring them or blaming them on other nations.  The ongoing crisis has shown that accounting control fraud in nations like the U.S., Ireland, Iceland, and Spain can cause the private sector to make trillions of dollars in destructive investments – sufficient to create massive bubbles and the Great Recession.  The entities that are supposed to be best at providing “private market discipline” – the banks – rendered themselves insolvent by funding these bubbles instead of preventing them.  These wasteful private sector investments should be a sovereign nation’s priority during the recovery from the Great Recession.  But the private sector’s staggering destruction of wealth should not blind a sovereign nation to the problems of its public sector – crippling problems in Greece and severe in Iceland, Spain, and Ireland.  The periphery needs to work in parallel on the interrelated crises of its private and public sectors.         

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Recent USA Sectoral Balances: Goldilocks, the Global Crash, and the Perfect Fiscal Storm

Posted on June 19, 2011 | 28 comments

In the previous blog, we did some heavy lifting. Unless you are an economics or accounting nerd, you found it quite boring. This week we will take a little break from pure accounting, and apply what we’ve learned to a real world example. By now, long-time readers are quite familiar with the NEP’s approach to the GFC (global financial crisis). Let us revisit the Clintonian Goldilocks economy to find the seeds of the GFC, using our sectoral balance approach.

To be clear, what follows uses our sectoral balances identity plus some real world data to provide an interpretation of the causes of the crash. As always, interpretations are subject to disagreement. The identity as well as the data are not. (You can of course always begin analysis with other identities and other data.) Next week we return to a bit more accounting.

Back in 2002 I wrote a paper announcing that forces were aligned to produce the perfect fiscal storm. (I note that in recent days a few analysts—including Nouriel Roubini—have picked up that terminology.) What I was talking about was a budget crisis at the state and local government levels. I had recognized that the economy of the time was in a bubble, driven by what I perceived to be unsustainable deficit spending by the private sector—which had been spending more than its income since 1996. As we now know, I called it too soon—the private sector continued to spend more than its income until 2006. The economy then crashed—a casualty of the excesses. What I had not understood a decade ago was just how depraved Wall Street had become. It kept the debt bubble going through all sorts of lender fraud; we are now living with the aftermath.

Still, it is worthwhile to return to the so-called “Goldilocks” period (mid to late 1990s, said to be “just right”, with growth sufficiently strong to keep unemployment low, but not so swift that it caused inflation) to see why economists and policymakers still get it wrong. As I noted in that earlier paper,

It is ironic that on June 29, 1999 the Wall Street Journal ran two long articles, one boasting that government surpluses would wipe out the national debt and add to national saving—and the other scratching its head wondering why private saving had gone negative. The caption to a graph showing personal saving and government deficits/surpluses proclaimed “As the government saves, people spend”. (The Wall Street Journal front page is reproduced below.) Almost no one at the time (or since!) recognized the necessary relation between these two that is implied by aggregate balance sheets. Since the economic slowdown that began at the end of 2000, the government balance sheet has reversed toward a deficit that reached 3.5% of GDP last quarter, while the private sector’s financial balance improved to a deficit of 1% of GDP. So long as the balance of payments deficit remains in the four-to-five percent of GDP range, a private sector surplus cannot be achieved until the federal budget’s deficit rises beyond 5% of GDP (as we’ll see in a moment, state and local government will continue to run aggregate surpluses, increasing the size of the necessary federal deficit). [I]n recession the private sector normally runs a surplus of at least 3% of GDP; given our trade deficit, this implies the federal budget deficit will rise to 7% or more if a deep recession is in store. At that point, the Wall Street Journal will no doubt chastise: “As the people save, the government spends”, calling for a tighter fiscal stance to increase national saving!

Turning to the international sphere, it should be noted that US Goldilocks growth was not unique in its character. [P]ublic sector balances in most of the OECD nations tightened considerably in the past decade–at least in part due to attempts to tighten budgets in line with the Washington Consensus (and for Euroland, in line with the dictates of Maastricht criteria). (Japan, of course, stands out as the glaring exception—it ran large budget surpluses at the end of the 1980s before collapsing into a prolonged recession that wiped out government revenue and resulted in a government deficit of nearly 9% of GDP.) Tighter public balances implied deterioration of private sector balances. Except for the case of nations that could run trade surpluses, the tighter fiscal stances around the world necessarily implied more fragile private sector balances. Indeed, Canada, the UK and Australia all achieved private sector deficits at some point near the beginning of the new millennium. (Source: L. Randall Wray, “The Perfect Fiscal Storm” 2002, available at http://www.epicoalition.org/docs/perfect_fiscal_storm.htm)

Let us revisit “Goldilocks” and see what lessons we can learn from “her” that help us to understand the Global Financial Collapse that began in 2007. As we now know, my short-term projections predicting the demise of Goldilocks into a recession were not too bad, but the medium-term projections were off. The Bush deficit did grow to 5% of GDP, helping the economy to recover. But then the private sector moved right back to huge deficits as lender fraud fuelled a real estate boom as well as a consumption boom (financed by home equity loans). See the chart below (thanks to Scott Fullwiler). Note that we have divided each sectoral balance by GDP (since we are dividing each balance by the same number—GDP—this does not change the relationships; it only “scales” the balances). This is a convenient scaling that we will use often in the MMP. Since most macroeconomic data tends to grow over time, dividing by GDP makes it easier to plot (and rather than dealing with trillions of dollars—so many zeroes!—we express everything as a percent of total spending).

This chart shows the “mirror image”: a government deficit from 1980 through to the Goldilocks years is the mirror image of the domestic private sector’s surplus plus our current account deficit (shown as a positive number because it reflects a positive capital account balance—the rest of the world runs a positive financial balance against us). (Note: the chart confirms what we learned from Blog #2: the sum of deficits and surpluses across the three sectors must equal zero.) During the Clinton years as the government budget moved to surplus, it was the private sector’s deficit that was the mirror image to the budget surplus plus the current account deficit.

This mirror image is what the Wall Street Journal had failed to recognize—and what almost no one except those following the Modern Money approach as well as the Levy Economic Institute’s researchers who used Wynne Godley’s sectoral balance approach understand. After the financial collapse, the domestic private sector moved sharply to a large surplus (which is what it normally does in recession), the current account deficit fell (as consumers bought fewer imports), and the budget deficit grew mostly because tax revenue collapsed as domestic sales and employment fell.

Unfortunately, just as policymakers learned the wrong lessons from the Clinton administration budget surpluses—thinking that the federal budget surpluses were great while they actually were just the flip side to the private sector’s deficit spending—they are now learning the wrong lessons from the global crash after 2007. They’ve managed to convince themselves that it is all caused by government sector profligacy. This, in turn has led to calls for spending cuts (and, more rarely, tax increases) to reduce budget deficits in many countries around the world (notably, in the US and UK).

The reality is different: Wall Street’s excesses led to too much private sector debt that crashed the economy and reduced government tax revenues. This caused a tremendous increase of federal government deficits. {As a sovereign currency-issuer, the federal government faces no solvency constraints (readers will have to take that claim at face value for now—it is the topic for upcoming MMP blogs).} However, the downturn hurt state and local government revenue. Hence, they responded by cutting spending, laying-off workers, and searching for revenue.

The fiscal storm that killed state budgets is the same fiscal storm that created the federal budget deficits shown in the chart above. An economy cannot lose about 8% of GDP (due to spending cuts by households, firms and local and state governments) and over 8 million jobs without negatively impacting government budgets. Tax revenue has collapsed at an historic pace. Federal, state, and local government deficits will not fall until robust recovery returns—ending the perfect fiscal storm.

Robust recovery will reduce the overall government sector’s budget deficit as the private sector reduces its budget surplus. It is probable that our current account deficit will grow a bit when we recover. If you want to take a guess at what our “mirror image” in the graph above will look like after economic recovery, I would guess that we will return close to our long-run average: a private sector surplus of 2% of GDP, a current account deficit of 3% of GDP and a government deficit of 5% of GDP. In our simple equation it will look like this:

Private Balance (+2) + Government Balance (-5) + Foreign Balance (+3) = 0.

And so we are back to the concept of zero!

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Obama’s Implausible Dream: Cut the Deficit without Destroying Jobs

Posted on June 17, 2011 | 28 comments

By Stephanie Kelton

White House Press Secretary Jay Carney recently explained President Obama’s “singular concern, which is that the outcome of the deficit reduction talks produce a result that significantly reduces the deficit while doing no damage to the economic recovery and no damage to our progress in creating jobs.”

Great. And I want to go on a donut diet and shed ten pounds.

As far as Washington is concerned, there are only two ways to bring down the deficit: cut spending or increase taxes. Both reduce private sector incomes.  This means that the president is looking for a way to reduce private sector incomes without hampering sales or job creation.

Can it be done? Let’s see.

Suppose the government decides to cut spending by $100. This means that someone in the private sector is receiving $100 less than they were getting before the government tightened its belt.  Ordinarily, we would expect this to generate an even bigger drop in GDP, as the decline in income leads to multiple rounds of contraction due to the effect of the multiplier.

For those that need a refresher, the multiplier is given by (1/1-b), where b = the marginal propensity to consume (MPC) or:

It shows the relationship between disposable income (Yd) and household consumption spending (C). As disposable income increases, we expect household spending to rise, making the value of the MPC > 0. But we also expect people to save a bit more, so the MPC < 1.

This means that we also have a marginal propensity to save, which is given by:

The MPS shows how saving changes in response to a change in disposable income. Like the MPC, the MPS is expected to be greater than zero but less than one. And, since you can only do one of two things with your disposable income – spend or save – the MPC and the MPS must always sum to 1. This is all basic Econ 101.

So let’s suppose that the MPC = b = .90, which means that people tend to spend, on average, $0.90 out of each additional $1.00 of income they receive. The other $0.10 is added to their savings. Now suppose that the government reduces its spending by $100. What will happen to economic activity as measured by output (Y) ?

After multiple rounds of spending reductions (the multiplier at work), output falls by $1,000. Ouch!

But the president is looking for ways to reduce the deficit without damaging the recovery or destroying jobs. So maybe a tax increase is the way to go. Let’s check.

A tax increase means less disposable income , and this means less spending by consumers. As before, a reduction in spending by one party (in this case the private sector) will result in several rounds of additional cuts, because of the multiplier effect. We can use the following equation to measure the macroeconomic effect of a change in taxes.

The large bracketed term is the tax multiplier, and it is used to demonstrate the macroeconomic effects of an increase/decrease in taxes. Since the president is trying to reduce the deficit, we should consider the effect of a $100 increase in taxes. If the MPC = b = .90 as before, we get:

In this example, output falls by $900, better than the previous outcome, but still not what Obama is looking for. So the challenge remains: How can the government reduce the deficit without negatively impacting economic activity?

As Warren Mosler pointed out, it would require Congress to tax where there is a negative propensity to spend and cut where there is a negative propensity to save.

What does this mean? A negative propensity to spend means that people would spend more if the government raised taxes and reduced their incomes:

Under these circumstances, the economy would benefit from, say, a $100 tax increase, because households would spend more even though their incomes were falling:

Similarly, if the government cuts spending where there is a negative propensity to save, then output and employment will increase even as the government tightens its belt.

But a negative propensity to save means that the MPC >1 because the MPS < 0 and they must sum to 1:

Under these conditions, a $100 cut in government spending results in:

But what are the chances of this happening in the real world?  Probably zero. Spending cuts and tax increases reduce private sector incomes.  And the private sector isn’t going to celebrate the loss of income by going on a shopping spree.

The bottom line is this: As long as unemployment remains high, the deficit will remain high.  So instead of continuing to put the deficit first, it’s time get to work on a plan to increase employment.

Here’s the formula: Spending creates income.  Income creates sales.  Sales create jobs.

If you think you can cut the deficit without destroying jobs, dream on.

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